The Health Care Bill and the Bond Markets

Five days after President Obama signed the Senate health care bill into law, a Wall Street Journal article spelled out how the federal government’s borrowing costs are rising due to “debt fears.” The yield on the 10 year Treasury note has increased by more than 0.2% since passage of the health care bill and now yields 0.71% more than comparable German government notes. The higher interest rates are required to compensate investors for the risk that the US government will default on its debt, or that the money used to repay creditors will have less purchasing power. The yield differential is consistent with spreads in the credit default swap market, which also suggest the US is less credit-worthy than Germany.

As for why we’ve seen this deterioration in the perceived creditworthiness of the US government, the most likely explanation is that creditors are skeptical about reverse-engineered scores by the Congressional Budget Office that suggest the health care law will curb deficits. The law creates a new entitlement that by 2018 will cost more than $200 billion per year and continue to grow by 7% per year thereafter. Yet to finance these new outlays, the law relies on cuts to Medicare payments that are viewed as “unrealistic” by the program’s actuary because they would cause providers to end participation in the program and jeopardize access to care for beneficiaries. The bond market recognizes that the amortization of a bond’s principal balance is dependent on politicians standing by while seniors are denied care. Given the likelihood that politicians will undo the measures that curtail care, bondholders are, justifiably, demanding a higher rate of interest.

The new entitlement is also financed through a new 3.8% tax on investment income and a 0.9% tax on the wages of households with more than $250,000 of gross income ($200,000 for single filers). This creates a profound mismatch between the volatility of the revenues coming in and the spending they are intended to support. Entitlement costs will continue rising, while the tax revenue from capital gains and high incomes will swing dramatically from year to year. One reason bond traders view Germany as a safer credit risk than the United States is because its tax system relies on more stable sources of revenue like consumption (turnover taxes). If Congress wishes to move the US towards a Franco-German welfare state, it needs to follow their lead on taxes as well as benefits.

The larger problem from a public finance perspective is that the new health-care law classifies these new receipts as “payroll taxes” and deposits them in the Medicare trust fund. Were these new revenues classified as “income taxes,” they would provide a dollar-for-dollar offset of new spending, but when classified as “payroll taxes” each dollar also disingenuously counts towards reducing Medicare’s deficit. Unlike the Congressional Budget Office, bond investors are not legally obligated to respect these misleading accounting practices.

The double-counting and unrealistic assumptions that are embedded in the health care law strengthen the perception that the US government lacks the seriousness necessary to confront the scale of its fiscal challenges. Creditors cannot be encouraged when they see a government with a deficit running at 10% of its country’s GDP enact into law a bill with explosive expenditures and highly contingent cost savings.

Shortly before passage of the health-care bill, the International Monetary Fund (IMF) released a working paper that finds the policies proposed by President Obama in the Fiscal Year 2011 Budget are likely to cause the public debt of the US to exceed 106% of GDP by the end of the decade. This debt estimate is nearly 30 percentage points greater than President’s budget; in nominal terms, the IMF estimate suggests that the President’s budget is underestimating the likely net increase in debt by $7 trillion (based on the President’s 2020 GDP projection of $24 trillion).

The IMF working paper makes a compelling case that the Office of Management and Budget (OMB) uses unrealistically low interest rates in its forecasts of future debt and deficit levels, assumes too rapid a recovery, and overstates the speed at which countercyclical entitlement expenditures will fall in response to economic growth. As the IMF explains (page 14), “aging and health related spending are not the key drivers of this debt build-up.” Indeed, policy choices are.

Optimism is nothing new. As the IMF explains, “the past record of budget projections shows a strong tendency for ‘optimistic’ budget forecasts.” With the exception of 1993 to 1997, OMB projections have underestimated the growth of deficits and debt. What’s different about the Obama team’s projections is the magnitude of their optimism. The IMF estimates that to stabilize debt below 70% of GDP would require a fiscal adjustment of about 3.5% of GDP. In nominal terms, that would require some combination of spending cuts and tax increases equal to roughly $600 billion in 2014 alone.

Without dramatic policy changes, the IMF estimates that interest expense on the public debt could rise by 1% to 2%. This is the same message sent by the bond markets. Although much of the focus is on the net increase in debt, the Treasury must also roll-over maturing obligations. The net debt increased by $1.78 trillion in fiscal year 2009, but the total amount of debt issued was $8.865 trillion. Higher interest rates apply not only to new bonds issued to finance the deficits associated with health care, but also to the existing stock of debt that needs to be refinanced in the future.

The budget practices that get a favorable score from CBO or that downplay future deficits haven’t persuaded the bond market. It recognizes what should be patently obvious: new entitlements don’t finance themselves. If the Obama Administration wants Franco-German social welfare spending levels, it needs to let the bond market know a Franco-German tax system is on the way as well.

A new report by the non-partisan Tax Foundation shows that America has higher capital gains tax rates than other industrialized countries. Nevertheless, President Obama is pushing Congress to raise taxes on capital gains still further. America’s tax treatment of capital gains already raises the cost of capital and reduces investment, and raising rates would create more disincentives to business investment and growth.

The economy is growing, labor markets have improved dramatically, and inflation is forecast to return to two percent over the intermediate term. However, the Fed still expresses extreme caution about normalizing monetary policy, citing myriad concerns, ranging from sluggish wage growth and low inflation to foreign economic and political risks, which might delay the date at which interest rates finally lift off their zero lower bound. This creates the potential for an erosion of the FOMC’s credibility and suggests the Fed lacks a clear strategy for getting monetary policy back on track.

Should the Federal Reserve conduct monetary policy using a monetary policy rule? This question, a classic one in economics, was raised again during Chair Janet Yellen’s recent Congressional testimony and has become the subject of intense debate since then.

If Federal Reserve policy makers were to look solely at headline labor market indicators, they might be tempted to conclude that the U.S. economy had finally reached cruising altitude. Yet nothing else has that '90s feel: not the pace of economic growth, not capital investment, not productivity growth, not even Nasdaq 5000. The juxtaposition of solid job growth and tepid economic growth describes what the current expansion lacks: dynamism and innovation.